|Shares Out. (in M):||158||P/E||NA||5.8x|
|Market Cap (in $M):||1,357||P/FCF||NA||NA|
|Net Debt (in $M):||8,793||EBIT||0||0|
KKR Financial Holdings LLC - Long
April 12, 2010
Current Price: $8.57
2010E Street EPS: $1.48
2010E P/E: 5.8x
2011E Street EPS: $1.61
2011 P/E: 5.3x
2009 YE Book Value: $7.37
Trailing P/B: 1.2x
52-week range: $0.75-$8.73
Equity Cap: $1.36 bn
Shares O/S: 158 mm shares
12 Month target: $18.00
Upside potential: 110%
Investment Recommendation: KKR Financial ("KFN") is an extremely undervalued specialty finance company principally invested (86%) in senior secured syndicated loans and high yield bonds (10%) of large companies. KFN represents a total return opportunity of 110% at current prices and as such is my largest position.
Executive Summary: KFN is a stock that will continue to benefit from the continuing recovery in corporate credit. The stock is extremely cheap on an absolute basis trading at 5.8x and 5.3x Street 2010 and 2011 EPS estimates and at 95% my estimate of current NAV/book value. My review of the top 80% of KFN's underlying credit positions (companies) gives me confidence that KFN's CLOs own high quality leveraged loans. The underlying credit positions are trading on average in the low 90s and are likely to continue to appreciate in price. I believe current 2010 and 2011 sell side earnings estimates ($1.48 and $1.61) are too low based on several factors that should allow KKR to increase EPS closer to $1.80 in 2011. These levers include:
I believe there are also several near term catalysts that will drive short to medium term stock price appreciation. Those catalysts include:
KFN is cheap trading at a very low multiple of 5.3x 2011 EPS estimates -- a significant and unwarranted discount to the two closest comparables which are trading at ~9x earnings. KFN and its comparables are also trading at a significant discount to historical multiples.
Announced specifics on additional credit investing opportunities will in turn cause investors to re-evaluate their assessment that KFN's future earnings power is tied to the issuance of new CLOs. Regardless of whether new CLOs are created in 2010 there remains a significant credit investing opportunity for KFN to pursue and investors in turn need to increase their estimate of normalized future earnings. In turn, I believe they will increase the multiple they are willing to pay for those earnings given KFN's extremely low valuation.
KFN then represents an investment with a strong fundamental outlook, who's ability to increase earnings is underappreciated, traded at a substantial discount to its closest comparables, which themselves are trading at a historic discount to typical "normalized" multiples. Most importantly, there are near term catalysts that should narrow the valuation discount.
My 2011 price target is $18 based on my 2011 EPS estimate of $1.80 at a PE multiple of 10x. I expect KFN's shares to rise to my price target in the next year based on continued increases in the Company's NAV, earnings growth, and an increased market multiple due to the previously mentioned catalysts.
Company Description: KKR Financial ("KFN") is a specialty finance company. The Company invests in financial assets including senior secured and unsecured loans, mezzanine loans, high yield corporate bonds, distressed and stressed debt securities, equity securities, and credit default and total rate of return swaps. The majority of KFN's investments are in senior secured syndicated loans of large capitalization companies (86% of the credit portfolio). Corporate bonds comprise another 10% of the investment portfolio. About 35% to 40% of KFN's securities and CLO assets are in KKR affiliated deals.
The majority of the corporate debt investments are held in Collateralized Loan Obligation ("CLO") transactions that are structured as on-balance sheet securitizations and are used as long term financing for these investments. The Company currently has five cash flow CLO transactions. The Company owns 100% of the economic interest in CLO 2005-1, CLO 2005-2, and CLO 2006-1 and the majority interest in CLO 2007-1 and CLO 2007-A.
KFN issued notes to banks and third parties to purchase the CLO assets. The CLO debt is collateralized by the CLO assets. KFN keeps the net interest income spread. The spread is earned from what the CLO assets yield (the syndicated loans average spread is 300 bps to 400 bps over LIBOR annually) over the finance costs. The CLO debt is priced and locked at a very attractive low interest rate of ~LIBOR + 100 bps.
The senior secured notes issued by the CLO transactions are generally owned by unaffiliated third party investors and KFN owns the majority of the mezzanine and subordinated notes in the CLO transactions. Income is generated primarily from interest income and realized gains/losses from the sales of investments.
Simply put, KFN's CLO investments are in subordinated securities issued by the CLO issuers, representing highly leveraged investments in the underlying collateral, which increases both the opportunity for higher returns as well as the magnitude of losses when compared to other investors in these CLO structures that rank more senior to KFN in right of payment.
The Company is externally managed and advised by KKR Financial Advisors LLC, which is a wholly-owned subsidiary of Kohlberg Kravis Roberts & Co., pursuant to a management agreement.
Collateralized Loan Obligations ("CLO") Structure: CLOs are a form of securitization where payments from syndicated bank loans pooled together and passed on to different classes of owners in various tranches. CLOs combine multiple syndicated loans but don't transmit the loan payments equally to the CLO owners. Instead, the owners are divided into different classes, called tranches, with the most senior class entitled to more of the interest payments than the next. The senior most tranche is also the last in line in absorbing any losses amongst the loan tranches due to loan defaults. Relatively safe senior tranches are paid lower interest rates (designed to appeal to conservative investors) and higher risk subordinate tranches are sold to higher risk investors (by offering a higher interest rate).
When the loans that the CLO holds are performing, the assets generate enough cash flow to pay the required interest on the CLO's debt with the remaining cash flow being distributed to the equity holders. Two key tests impact cash flows and are set up to protect the CLO's senior debt holders: the interest-coverage ("IC") test and the over-collateralization ("OC") test. The IC test reflects the amount of interest income necessary to service the senior debt. The OC test measures the ratio of the collateral value of the assets in each CLO to the amount of the debt issued. The collateral value of the assets in each CLO is generally par, with three exceptions:
purchase price into the CLO below 80% of par for loans and 75% of par for bonds.
When either the IC or OC test is out of compliance, the interest cash flows that would otherwise be
payable to the mezzanine and subordinate note holders, including the Company, are used to amortize the
most senior class of notes until the respective test is back in compliance. When the syndicated loans are exited through re-financings, recapitalizations, or IPOs, the CLO debt is paid off.
Background: As the credit crisis unfolded in late 2008 and early 2009 among the sectors particularly challenged by the current crisis in the global credit markets were the CLO and leveraged finance markets. Liquidity in the credit markets was drastically reduced, resulting in an increase in credit spreads and a decline in ratings, performance and market values for leveraged loans. The S&P/LSTA 100 Leveraged Loan Index fell from the mid-90s at the start of 2008 to the low-60s in the first quarter of 2009. The issuers of the syndicated loans held in KFN's CLOs experienced an increase in downgrades and substantial decreases in market value and increases in defaults in late 2008 and early 2009. During the 4th quarter of 2008 and 1st quarter of 2009, the loans that KFN held in their CLOs experienced pricing declines comparable to the pricing declines seen in the LSTA index. The underlying loans held in KFN's 5 CLOs also experienced substantial rating agency downgrades over that same time period.
Due to falling loan prices and ratings agency downgrades, the calculated asset prices of the holdings in KFN's CLOs significantly declined and certain of KFN's CLOs began failing their respective OC tests. In the first quarter of 2009, 4 of KFN's 5 CLO's were failing one or more of their OC tests, which caused the diversion of cash flows away from KFN as holders of the more junior CLO securities in favor of investors more senior than KFN in right of repayment, until the relevant OC tests were satisfied.
KFN's stock price fell from ~$14.00 per share at the start of 2008 to a low of $0.42 per share in the first quarter of 2009 due to the aforementioned OC test failures, and commensurate reduction in cash flows, and due to the collapse in prices in the syndicated loan market. KFN's stock price was also hammered by market concerns over KFN's substantial balance sheet leverage which included substantial near term maturing debt.
KFN eliminated their $.0.20 cent/per share per quarter dividend payout in late 2008 in an effort to preserve liquidity. KFN also put in new management, raised a little equity, restructured some of the CLO structures and agreed to give up a portion of cash flows to bring 2 of the CLOs into compliance and improve cash flow. Essentially a large portion of KFN's spread was used to pay down senior debt in its CLOs until certain OC tests were passed.
Recent Events/OC Tests: On their 4th quarter and year end earnings call on March 1, 2010, KFN announced that 4 of the 5 KFN CLOs were meeting their OC tests (due to the aforementioned actions and due to price appreciation of the loans held in the CLOs) and that the 5th CLO was partially cash-flowing. Specifically, KFN said that the 5th CLO, 2007-1, was meeting its senior OC test but failing its subordinate OC test. The Company went on to say that absent unforeseen events they expect 2007-1 to become compliant with its subordinate OC test in the second or third quarter of 2010.
Recent Events/Capital Structure: In January of 2010, the Company issued $172.5 mm of 7.5% 7-year convertible notes. The transaction was completed with an initial conversion price of $8.18 per share. Proceeds were earmarked to reduce existing indebtedness. Since the completion of the offering, KFN has reduced borrowings outstanding under their senior credit facility to $150 mm (from $175 mm) and the Company has repurchased $90 mm of their 7% 2012 convertible notes, which leaves a current outstanding balance of $181 mm.
In August of 2009, the Company amended and extended the terms of its senior secured credit facility. Among other things, the amendment reduced the size of the facility to $200.0 mm from $300.0 mm, provided for quarterly amortization of $12.5 million per quarter until the size of the facility has been reduced to $150 million on June 30, 2010, increased the borrowing rate under the facility from LIBOR plus 300 bps to LIBOR plus 400 bps, reduced the adjusted tangible net worth covenant from $700.0 million from $1.0 billion, and extended the maturity date of the facility to November 10, 2011. Amendments also restrict the Company from paying shareholders a dividend of more than 50% of yearly taxable income.
Recent Events/4Q and YE 2009 Earnings: Operating income for the fourth quarter which KFN defines as net investment income plus non-invested expenses totaled $65.1 million or $0.41 per diluted common share as compared to 54.2 million or $0.35 per diluted common share for the third quarter. Included in net investment income are one-time capital gains from early prepayments of investments at par and at a premium to where they were marked. When adjusted to exclude these one-time gains, pro forma operating income for the fourth quarter was 55.1 million or $0.35 per common share and pro forma operating income for the third quarter is 51.5 million or $0.33 per common share. (Note that net operating income and net income are identical figures because KFN is a publicly traded partnership which allows the Company to avoid double taxation for their shareholders.)
The difference between operating income for the quarter of $0.41 per diluted share and net income of $0.01 per diluted common share is attributable to other net losses of 62.9 million. The largest contributor to this loss was a write-down of KFN's residential mortgage-backed securities portfolio held primarily their REIT subsidiary during the quarter of 62.5 million. The charge reflects KFN's negative outlook for prime mortgage loan performance based on current market factors, most notably increased expectations regarding expected delinquencies and losses on the residential mortgage loans in their RMBS positions. As of December 31st, KFN's RMBS portfolio had holdings at an aggregate par value of 278.4 million and an aggregate fair value estimated at 121.9 mm. At year end, the Company's RMBS holdings constituted less than 3% of their total portfolio.
Portfolio Composition: The loans held in KFN's CLOs are large capitalization syndicated loans that were sold in 2005, 2006, and 2007. KFN's specific loan portfolio is very transparent. The Company's quarterly supplemental materials disclose in rank order the Company's Top 50 holdings by estimated fair value. The Company also disclosed that, as of 12/31/09, the top 50 holdings represent 78% of the corporate debt portfolio and the top 20 holdings represent 52% of the corporate debt portfolio.
Portfolio Assessment: I am comfortable with both the quality of the composition of KFN's top 50 holdings and how accurately (as opposed to "aggressively" or inaccurately) KFN has the portfolio marked. I measure the quality of KFN's underwriting by their experienced default rate to date and the quality of the current portfolio by the current trading price (and sequential trend in prices) of the Company's largest loan positions.
By both measures KFN scores quite favorably.
KFN's annualized default for the entire year was 6.2% as compared to the loan index default rate of 9.6% and their weighted average recovery rates based on the cost basis of their investments was 66%, as compared to industry rates of 49% for leveraged loans and 23% for high yield bonds. In addition, they experienced significant improvement in default rates during the latter part of 2009 with an annualized default rate for the second half of 2009 of 90 bps.
Portfolio Pricing: I was able to obtain loan prices on 20 of 25 of the Company's top 25 positions and 40 of 50 of the Company's largest 50 debt positions. I sought (and successfully) obtained year end 2009 and first quarter end 2010 broker dealer loan quotes on those positions. In summary, 17 of the top 20 positions are currently trading above 88 cents on the dollar. Only TXU and Tribune and Lyondell (which both filed for bankruptcy in late 2008 and early 2009, respectively) were trading below 88. The average loan price of KFN's top 20 (remember I had access to pricing for 20 of the top 25 positions) corporate debt positions increased from 88.6 to 91.5 in the first quarter of 2010 or 3.25% and the price of every position increased or was approximately flat from year end 2009 vs. the end of the first quarter of 2010.
Further, I calculated the average price of KFN's top 50 debt positions as of year end at ~90 cents (or 90% of par) vs. the weighted average market value of corporate debt portfolio of 89% of par reported by the Company. We do not know which of the top 50 reported holdings might be bond positions (as opposed to loans) but since 86% of the corporate debt portfolio is comprised of loans I think this is a minor point. The Company's (self reported) market value of their corporate debt portfolio when coupled with default reserves and compared against their liabilities translates into an estimate of Net Asset Value. The available empirical evidence to me (based on my research on the market value of the underlying positions they own) is consistent with KFN's valuation and gives me confidence in their calculation of NAV.
Net Asset Value/Book Value: NAV or book value as of year end (12/31/09) was $7.37 per share based on total shareholder's equity of $1.17 bn and ~158 mm shares outstanding. NAV compared favorably to the firm's NAV at the end of the third quarter ($7.01) and the prior year end ($4.40). Book value per share is predicated on two key underlying assumptions:
As discussed previously, I believe management's reported "estimated fair value" of the corporate debt portfolio (87% of par as of year end) is in fact a good estimate of the portfolio's underlying value given it's consistency with my own research into the loan prices at year end of the Company's top 50 positions (90% of par (average price) vs. 87% reported by the Company).
Estimated Future NAV: I estimate that the Company will report NAV at the end of the first quarter of 2010 of approximately $9.05 per share. My estimate is based on an increase in book value from $7.30 bn to $7.57 bn, or $270 mm or $1.68 per share, based on an estimated increase in the market value of KFN's corporate debt holdings of 3.65% which is directionally consistent with the increase in the average price of the S&P/LSTA Leveraged Loan 100 Index which increased in price from 87.68 to 91.76 or 4.7% during the quarter. My estimate of the KFN book value increase in based on the estimated price increases of KFN's top 50 positions which increased from ~89.6% of par to 93.2% of par or 3.9%. Prospectively, I expect the book value of the current portfolio to increase, although more modestly, due to the refinancing of existing loans by bond takeouts, due to amend-and-extend transactions, and due to the execution of IPOs by certain borrowers (which usually causes the issuers associated bank debt to trade up).
Fundamental Credit Market and Issuer Outlook: Recent performance of the loan market has been very strong based on an improving fundamental outlook for borrowers and strong technical conditions. The greater than expected ability to refinance has enabled many borrowers to survive the credit cycle much better than had been originally expected. The positive overall fundamental picture is further highlighted by several recently published metrics by S&P.
2010 and Beyond Earnings Expectations: As previously mentioned, KFN reported operating earnings (essentially equivalent to net income because they are not a tax payer) of $0.41 cents/per share in the fourth quarter. That represents $1.64 per share on an annualized basis which management thinks is a reasonable expectation of 2010 earnings (although they do not formally give guidance). The two sell side analysts who actively follow the name are estimating earnings of $1.48 a share in 2010 and $1.61 a share in 2011. I believe earnings estimates for 2010 are low and that several factors should allow KKR to increase EPS closer to $1.80 in 2011. These levers include:
Each of these scenarios represents an opportunity for KFN to increase the interest earned on their portfolio.
Management and Incentives: William Sonneborn was hired as the CEO in December 2008. Prior to joining KKK, he spent over 10 years at TCW Group, Inc. most recently as President and COO of The TCW Group and CEO of The TCW Funds. Incentive compensation, paid to the external manager KKR Financial Advisors (and in turn to Sonneborn), is tied to reported earnings (net income).
Insider Buying: On March 9, 2010, Sonneborn purchased 20,000 shares of KFN in the open market at $7.42 a share. On March 17, 2010, Scott Nuttall, a board member and head of KKR's financial services group, bought 10,000 shares in the open market at $7.72 per share.
Valuation: KFN's stock is very cheap. The stock is trading at a multiple of 5.8x and 5.3x consensus Street EPS estimates for 2010 and 2011, respectively. KFN is trading even cheaper based on my 2010 and 2011 EPS estimates of 5.2x and 4.8x, respectively. The closest comparables, business development companies (BDCs) Ares Capital (ARCC) and Apollo Investment (AINV), are trading at ~10x and ~9x projected 2010 and 2011EPS. On a trailing basis, KFN is trading in line with Ares and Apollo at ~1.2x price/book. KFN, ARCC, and AINV, are all trading at a significant discount to where they traded in 2006 and 2007. At that time the stocks traded at P/E multiples of 12-15x earnings. KFN's multiple discount vs. its peers is probably attributable to the stock's much lower dividend yield (~3% vs. ~9%). That said, the discount seems unwarranted and extreme.
ARCC and AINV are comparable to KFN because they are also leveraged credit investors. However, KFN's loan portfolio is substantially different from the loan portfolios of ARCC and AINV. The vast majority of KFN's portfolio is invested in 1st lien bank loans whereas ARCC and AINV peers tend to be principally invested in 2nd lien, mezzanine, and equity securities. Large cap senior secured loans have experienced lower default rates and higher recoveries on defaulted loans than the middle market subordinate debt AINV invested in. (ARCC has experienced comparable default rates as KFN.) Further, the vast majority of the loans in KFN's CLOs are actively traded and liquid (in terms of purchase/sale) whereas the majority of loans held by ARCC and AINV were self originated or infrequently trade.
I believe these distinctions are strong arguments for a case that KFN should trade at par, if not at a premium to, the aforementioned comps. These distinctions, in KFN's favor, have been ignored by equity investors.
In summary, KFN is extremely cheap on an absolute basis, trading at a substantial discount to its closest comparables, which themselves are trading at a historic discount to more typical "normalized" multiples.
Variant View/Why Mispricing Exists:
"We don't view our business as depending on CLOs for growth . . . Syndicated corporate debt is and will be a key component of our business but it won't be our entire business. We are witnessing opportunities to meaningfully deploy capital to unique and special situations which range from private debt transactions that we source to controlled, distressed mezzanine opportunities . . . The next area is private equity . . . Through our industry leading role in this asset class we expect there to be a growing array of opportunities for KFN to deploy capital side-by-side with KKR Private Equity in select private equity investment opportunities. We are also seeing opportunities from KKR's infrastructure and energy teams to invest in physical assets driven by the global demand for infrastructure."
Of course, these market opportunities are currently a "show-me story." In the next couple quarters however I expect KFN to announce a significant number of attractively-priced high spread credit investments that add diversity away from their portfolio that is largely comprised of senior secured bank loans.